1. Operational Risk Chapter 18
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

2. Definition of Operational Risk
“Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events”
Basel Committee Jan 2001
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

3. What It Includes
The definition includes people risks, technology and processing risks, physical risks, legal risks, etc
The definition excludes reputation risk and strategic risk
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

4. Regulatory Capital (page 369)
In Basel II there is a capital charge for Operational Risk
Three alternatives:
Basic Indicator (15% of annual gross income)
Standardized (different percentage for each business line)
Advanced Measurement Approach (AMA)
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

5. Categorization of Business Lines
Corporate finance
Trading and sales
Retail banking
Commercial banking
Payment and settlement
Agency services
Asset management
Retail brokerage
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

6. Categorization of risks
Internal fraud
External fraud
Employment practices and workplace safety
Clients, products and business practices
Damage to physical assets
Business disruption and system failures
Execution, delivery and process management
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

7. The Task Under AMA
Banks need to estimate their exposure to each combination of type of risk and business line
Ideally this will lead to 7×8=56 VaR measures that can be combined into an overall VaR measure (Chapter 21 will discuss how this can be)
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

8. Loss Severity vs Loss Frequency (page 371)
Loss frequency should be estimated from the banks own data as far as possible. One possibility is to assume a Poisson distribution so that we need only estimate an average loss frequency. Probability of n events in time T is then
Loss severity can be based on internal and external historical data. (One possibility is to assume a lognormal distribution so that we need only estimate the mean and SD of losses)
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

9. Using Monte Carlo to combine the Distributions (Figure 18.2)
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

10. Monte Carlo Simulation Trial (page 372)
Sample from frequency distribution to determine the number of loss events (=n)
Sample n times from the loss severity distribution to determine the loss severity for each loss event
Sum loss severities to determine total loss
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

11. External Historical Loss Severity Data
Two possibilities
data sharing
data vendors
Data from vendors is based on publicly available information and therefore is biased towards large losses
Data from vendors can therefore only be used to estimate the relative size of the mean losses and SD of losses for different risk categories
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

12. Scaling for Size (page 374)
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

13. Other Techniques Scenario Analysis Identifying Causal Relationships
RCSA
KRI
Scorecard approaches
The power law
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

14. Insurance (page )
Factors that affect the design of an insurance contract
Moral hazard
Adverse selection
To take account of these factors there are
deductibles
co-insurance provisions
policy limits
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009

15. Sarbanes-Oxley (page 379)
CEO and CFO are more accountable
SEC has more powers
Auditors are not allowed to carry out significant non-audit tasks
Audit committee of board must be made aware of alternative accounting treatments
CEO and CFO must return bonuses in the event financial statements are restated
Risk Management and Financial Institutions 2e, Chapter 18, Copyright © John C. Hull 2009